The Federal Reserve System (Fed) is the United States central bank formed in 1913 "to provide the nation with a safer, more flexible, and more stable monetary and financial system."[1] The current Federal Reserve Chair is Janet Yellen, who was confirmed by the Senate on January 6, 2014.[2][3] The position comes with a four year term.

While established by Congress, the actions of the Federal Reserve do not have to be approved by any member of the executive branch, including the president. Congress does, however, have the power to pass laws in order to oversee the actions of the Federal Reserve.[4]

History

Early central banks

Three central banks existed in the United States before the Federal Reserve came into existence. The First Bank of the United States was established in 1791 in large part because of Alexander Hamilton, but after its initial 20 year charter, Congress voted against renewal. The War of 1812 then caused issues with the security of banking and credit leading to a second attempt at a central bank. The Second Bank of the United States was formed in 1816. Citizens were skeptical of the power of both of the first two central banks, and once again, the bank's charter was not renewed after 20 years. The National Banking Act of 1863 provided federal banking oversight by creating the Office of the Comptroller of the Currency. The depression in 1893, however, caused uncertainty in the sustained strength of the economy.[5]

Fed's formation

President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913, following a series of bank failures and financial panics. The idea for the Federal Reserve System came from ideas proposed by the National Monetary System after the Panic of 1907.[4] The Federal Reserve Banks were all open by November 16, 1914.[6] Throughout World War I, the Federal Reserve was able to aid in supporting the war effort in Europe before helping the U.S. fund its entry into the war. Following the war, New York Fed President Benjamin Strong, began using open market operations to influence credit by purchasing a large amount of government securities. This strategy was then followed by the entire Federal Reserve System as well as the Bank of England among other central banks. [6]

Reforms

A crowd gathered on Wall Street after the stock market crash in October 1929.

However, in 1929, the stock market crashed, beginning the Great Depression as banks began to fail. The Glass-Steagall Act passed in 1933, separating commercial and investment banking and establishing the Federal Deposit Insurance Corporation (FDIC). The Banking Act of 1935 formed the Federal Open Market Committee as part of the Federal Reserve System and removed the Treasury Secretary from the Federal Reserve's Board of Governors. The Treasury-Fed Accord was struck in 1951 after a debate between the Federal Reserve and the Truman administration over control of interest rates. The independence of the Federal reserve was solidified by the Accord as it "eliminated the obligation of the Fed to monetize the debt of the Treasury at a fixed rate."[6] In 1978, the Humphrey-Hawkins Act required the Chair of the Federal Reserve to testify before Congress twice a year.[6]

Modern banking period

Following a period of high inflation during the 1970s, the Monetary Control Act of 1980 forced the Federal Reserve to keep financial services' prices competitive with private businesses and to set reserve requirements for financial institutions, marking a move into the modern banking reforms. The 1990s saw the largest economic expansion in U.S. history. In 1999, the Gramm-Leach-Bliley Act overturned part of the Glass-Steagall Act, allowing commercial, insurance and investment activities to be provided by the same institution. The Fed reacted briefly to the September 11, 2001, terrorist attacks in order to stabilize markets.[6]

Financial crisis

Low mortgage rates in the early 2000s created a financial bubble in the housing market with home ownership possible for more people and riskier mortgages were securitized, which allowed people with poor credit purchase houses they couldn't afford. The temporary increase in demand increased the price of houses, until 2006, when prices began to fall sharply. Homeowners began to owe more on their houses than the houses were worth and owners began to default on their mortgages. In late 2008, financial institutions Lehman Brothers and Washington Mutual failed. In reaction to that, the Federal Reserve made loans to JP Morgan Chase, and American International Group (AIG). After looking into the 19 largest banks in the U.S. in 2009, it was determined that banks without enough money to protect themselves from loan losses needed to either accept money from the Troubled Asset Relief Fund or raise capital from the private sector. The federal funds rate was taken to the lowest it had been in 50 years and as a further measure, the Federal Reserve engaged in large-scale asset purchases, including the $1.25 trillion authorization for the federal government to purchase mortgage-backed securities from Freddie Mac and Fannie Mae.[7]

Structure

Mission

The Federal Reserve's original mission statement was as follows:

“

To provide for the establishment of Federal reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes.[8]

Leadership

The Chair of the Board of Governors is the leader of the Federal Reserve System. Janet Yellen currently holds the position. The Chair oversees the Federal Open Market Committee, testifies before the United States Senate twice a year, on or around February 20 and July 20, and meets with the president and Secretary of the Treasury regularly. Internationally, the Chair is an alternate member of the International Monetary Fund Board of Governors and a member of the U.S. delegation to the Group of Seven (G7) among participation in other international organizations.[4]

Board of Governors

A seven member Board of Governors is appointed by the president and confirmed by the Senate to 14 year terms. The long terms were formed with the intention of isolating the Board from short term political pressure.[10] Members of the Board analyze domestic and international economic developments, supervise the Federal Reserve Banks, play a role in the federal government's payment system and administer consumer credit protection laws. The Board oversees 900 state member banks and 5,000 bank holding companies.[4]

Reserve Banks

There are 12 Federal Reserve Banks broken into Federal Reserve Districts and 24 additional branch banks in the United States. The Reserve Banks help set monetary policy, bring money into and remove money from circulation, provide the Treasury Department with checking accounts and oversee member banks. The Federal Reserve Banks and their Districts are as follows:[11]

Federal Open Market Committee

The Federal Open Market Committee, consisting of 12 voting members, holds eight meetings annually to determine monetary policy. Five rotating Reserve Bank presidents and seven members of the Board of Governors are the voting members presided over by the Chair of the Board of Governors. All 12 District presidents are present for the meetings, and the New York District president is vice chair of the Committee as the New York Reserve Bank carries out the policies enacted. Voting presidents hold a one year term before the Committee rotates in presidents from other districts.[10] A vote is made on policies during the final day of each meeting with to determine policies and they are recorded in the Summary of Commentary on Current Economic Conditions by Federal Reserve District, commonly referred to as the Beige Book.[11][10]

Monetary policy

Guides

In order to determine whether the changes agreed to by the Federal Open Market Committee are achieving the intended goals, certain guides are used in an attempt to track changes in the economy. According to the Federal Reserve, the most frequently mentioned guides to monetary policy are:

Monetary aggregates

Interest rates

The Taylor Rule

Foreign exchange rates

While each guide has advantages, none are certain indicators of the impacts of monetary policies on the economy. This causes policy makers to employ many different indicators to determine whether changes in policy are meeting their intended goals and if not, what changes can be made.

Implementation

Federal funds rate

The Federal Reserve controls federal funds rate, the rate that member banks trade surplus and deficit balances with each other. It controls the rate in four ways to implement monetary policy:

“

Open market operations--the purchase or sale of securities, primarily U.S. Treasury securities, in the open market to influence the level of balances that depository institutions hold at the Federal Reserve Banks

Reserve requirement--requirements regarding the percentage of certain deposits that depository institutions must hold in reserve in the form of cash or in an account at a Federal Reserve Bank

Contractual clearing balances--an amount that a depository institution agrees to hold at its Federal Reserve Bank in addition to any required reserve balance

Discount window lending--extensions of credit to depository institutions made through the primary, secondary, or seasonal lending programs[8]

”

—FederalReserve.gov, "overview"/>

Unconventional policy

When the federal funds rate is dropped as low as it can go and the Federal Reserve determines more action is necessary, unconventional policies are used to ease policy. The three general areas of unconventional policy include "increasing the size of the Fed’s balance sheet; altering the composition of its balance sheet; and providing increasingly detailed guidance about the likely future path of policy."[12] Expanding the Federal Reserve's balance sheet includes large-scale asset purchases, or quantitative easing, which was used at the end of the Bush administration and throughout the Obama administration in an attempt to lower market interest rates.

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